Debtful future with ‘silver’ lining

During monetary tightening short term debt is one of the best instruments you can bet on. Turning to the short end of the yield curve limits your risk, your portfolio can trace policy rates, and gives you the freedom of liquidity. The strategy won’t turn you into a self-made millionaire – unless you are already one – but provides a prudent way to hedge against rising interest rates. If you were following the markets in recent weeks, you might have noticed something irregular. The difference between 6-month and 3-month T-bills turned negative, which means that quarterly paying bills yield higher returns. (see graph)

If you are familiar with the importance of yield curves you know what it means. If you are new to the topic let me sum it up for you. The longer the duration, the higher the interest rate is supposed to be. The reasons include liquidity, interest rate, and default risks. Furthermore, the shape of the curve follows the expected policy rate between maturities, making it one of the most reliable indicators when it comes to forecasting recessions. If you want to know more about its predictive qualities click here. Since we are in the middle of a tightening cycle and interest rates don’t tend to go back and forth within a couple of months, we can conclude that policy rate expectations play little role here; it must be something from a risk perspective.

As the end of September is approaching, the U.S. Congress is supposed to create the budget for next year, however, there is a bump on the road. The debt ceiling is in the way.

A little background about the debt ceiling: the measure was introduced in 1917. As a part of its involvement in World War I, the U.S. acquired debt from the private sector in order to finance its operations and its allies in the Old World. Since its establishment Congress had to approve new debt issuance, but the wartime required a more time efficient measure. The Second Liberty Bond Act made this time efficient solution feasible by only limiting the amount of new bonds issued. To reach its current shape, a second World War was needed. The debt ceiling reached its current form in the early years of World War II, accounting for gross federal debt in nominal terms.

I have a couple of problems with the measure. Firstly, it measures gross debt. Given that the government acquires assets, and not just fills the gap in the budget, the gross number might give you a false impression about the indebtedness of the system. For a real life example look up the difference between Japan’s gross and net national debt figures. Almost a 100 percent difference. Secondly, it is in nominal terms. Inflation and increasing economic activity (ceteris paribus regarding taxation) makes it easier to service nominal debt mountains. Fixing nominal levels result in a volatile real burden, often in the way of supportive – or at least not restrictive – economic policy, assuming a growing business activity.

The new budget, proposed by the Trump administration, is about to hit the ceiling. If it can not be raised, the Congress has to find alternative financing solution to borrowing, or risk a shut down. Before we get back to those sweet, inverse short-term yield curves, let me write a couple of words about public financing.

Most entities in the economy- let it be a household, firm, or municipality – rarely aim to deleverage by paying back nominal amount of debt. The most common way is to raise capital either from the market, or gradually by improving revenue streams. The Federal Government is not an exception. Paying back one bond means issuing new ones and rolling the debt, keeping the size of the balance sheet up. Hence, if they can’t refinance, the default risk is increased. Now get back to the bonds.

The ones which are going to mature 3 months from now are just after the predicted hit of the ceiling. Without a solution, repayment might come short. Before you get the wrong idea, I don’t say that the US will default. It just got itself into an interesting situation which is enough to create some turbulence on the T-bill market. Personally, I think it is a good opportunity with limited risk to get ahead of the Fed tightening curve and get a couple of basis points for ‘free’.

Bad solution, worse solution – the old stock and flow argument

One of my favourite point is when they confuse stocks and flows in the economy. I admit, it’s not straightforward, as most of the stocks have been flows at some time, and some assets – such as capital instruments – can be both at the same time for different parties. If you are interested in the topic, I can recommend reading Minsky’s ‘Stabilizing and unstable economy’.

Once again in monetary history, precious metals can offer a way out from the malaise. I have read two interesting alternative solutions to raising the ceiling. Firstly, we have the Trillion Dollar Coin. The monopoly of minting coins is still in the hands of the Treasury. With minting a coin and selling it to the Fed the Treasury would effectively engage in debt monetization, as the coin has no intrinsic value. This would either inflate the Fed balance sheet even further, opposite to the monetary policy aim, or would create a theoretically insolvent Federal Reserve system by writing off the value of the coin from the books just as it were a zero-coupon perpetual asset – what it effectively would be. Regarding the consequences of the first case let us see the second solution.

The second solution, even though involving precious metal (re)valuation as well, is less unorthodox. However, it would require the Fed to play the role of an investment bank or hedge fund, which it is not. The solution concerns the gold reserves of the government. Long story made short: during the 1930s everyone in the US had to sell their gold to the Fed, which amount was later sold to the Treasury in exchange of gold certificates at $20.67 per ounce. The certificates were reevaluated during the subsequent decades, all the way up to $42.22 per ounce. Today’s market price of ~$1250-1260 dwarfs the official value of the stock. By reevaluating the certificates the Fed could book an eye-watering $315 billion, which could be matched by government deposits on the liability side. Again, pretty much smells like QE.

The problem is that it would be hard to reverse the revaluation as it would cause respective accounting losses. So what happens if the Fed keeps the Trillion Dollar Coin or the reevaluated gold certificates on its balance sheet?  Here comes the problem of stocks and flows. In both cases the asset the Fed would hold is a stock, generating no income. On the other side of the balance sheet they would hold deposits – possibly converted into bank deposits sooner or later – which are cash flows, costing interest (currently costing 1.25 percent annually).

This gold trick probably won’t be implemented, as the Fed is not willing to engage in sneaky QEs. Fortunately, these are not the only, but certainly among the most unusual solutions, worth playing around and asking ‘what if’ questions.


Source: Bloomberg Marketsshort yield spreads US


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